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Update on Section 529 Plans

A section 529 plan is a program established and maintained by states or instrumentalities of the state that allows taxpayers to contribute to either a prepaid educational service account (i.e., prepaid tuition account) or an education savings account (which is similar to a Roth IRA) for a designated beneficiary. All contributions to 529 plans made by the donor grow tax free and are distributed tax free as long as the funds are only used to pay for a student’s qualified education expenses at an eligible educational institution.

Qualified Education Expenses
Eligible expenses are any expenses required for enrollment or attendance at an eligible educational institution. These expenses include:

• tuition
• room and board
• fees
• books
• computer equipment and services (i.e., internet access and educational software) – only for 2009 and 2010. In general, computer technology expenses are not qualified expenses for other education credits like the American Opportunity credit, Hope credit, or Lifetime Learning credit.

Eligible Educational Institution
529 Plans can only be used for higher education expenses. Eligible educational institutions are any college, university, vocational school, or other postsecondary educational institution, including graduate programs, eligible to participate in a student aid program administered by the Department of Education

Contribution Limitations
While there is no income threshold limiting who can contribute to a QTP, the total amount that can be contributed has an upper limit. This limit varies from state to state, but the  range is from $224,465 for Louisiana to $386,600 for Pennsylvania. The limits are an effort to deter contributions “in excess of those necessary to provide for the qualified higher education expenses of the beneficiary” [Sec. 529(b)(6)]. There is no ceiling on annual contributions.

Since contributions to a 529 plan are for the benefit of the designated beneficiary, the amounts are treated as gifts; however, contributions that are in excess of the annual gift exclusion do not necessarily have gift-tax consequences. When setting up a QTP, it is possible for each taxpayer to elect to use up to five annual exclusions for each beneficiary, and therefore each parent or grandparent can contribute up to $65,000 ($13,000 gift-tax exclusion x 5 years) without any tax consequences. It should be noted that by contributing in this manner the taxpayer will impact one’s ability to gift in the  4 succeeding years.

Distribution Rules
Distributions from 529 plans are not taxable as long as they do not exceed the student’s adjusted qualified educational expenses, which comprise the total of all qualified expenses less any tax-free educational assistance such as scholarships or grants for the related tax year. Any distributions that do exceed the qualified expenses are to be included in the beneficiary’s gross income subject to tax as well as an additional 10% penalty.

What To Do With an Underperforming 529 Plan
Many taxpayers are reassessing all of their investments after the difficult times the market faced in 2008 and 2009, and while many are wary of any plan that can be market sensitive, 529 plans have built in a great deal of flexibility for investors when things are not going their way. 

• The first and simplest way to reverse a declining 529 plan is to change your investment choices within the plan. Once a year, the asset allocations of a plan can be changed and, depending on the stability of the market, the IRS has been known to allow two investment allocation changes, as they did in 2009. Investors and their advisors should take advantage of this benefit to annually evaluate the investment advantages and disadvantages of their current 529 plans. When analyzing a 529 plan, emphasis should be placed on factors such as the length of time until the funds will be used, investment costs, and current market conditions.
• Another way to turn around an investment that is not performing is to transfer 529 plans. Annually, taxpayers can transfer funds tax free from one plan to another as long as the transfer takes place within 60 days. A major benefit of this option is that changing the plan or the beneficiary can alter the investments available or the length of the plan, creating a better investment situation. However, if the taxpayer is transferringfroma plan in State A to a plan in State B, special attention should be paid to whether there are any limitations or penalties with each state-specific plan.
• The final option is to close the account. If the current fair market value of the assets is less than what was originally contributed to the plan, you can fully liquidate the account and take an ordinary loss. This loss is treated as a miscellaneous itemized deduction subject to the 2% floor. However this is not beneficial for those taxpayers who are subject to Alternative Mminimum Tax. The amount that is withdrawn when the account is closed is not subject to federal tax and is not penalized federally, but there may be state tax consequences.

Illinois Bright Start College Savings Program
While most states offer their own college-savings plans, Illinois’s stands out as having one of the lowest investment costs with expense ratios ranging from 0.20% to 0.22%. An additional benefit for Illinois resident taxpayers is that any contribution to an Illinois plan, up to $10,000 for individuals and $20,000 for married couples filing jointly, is deductable on their Illinois income tax return. Note, there is no carryover of excess deductions from year to year.

Thirty-four states and the District of Columbia offer some form of tax incentive for investing in their college-savings plan. Taxpayers should contact their tax preparer or account representative to verify state-specific information.

Selecting the most beneficial 529 plan can require a great deal of time and research since most plans offer a wide variety of investment options, from stock and bond funds to money market accounts to federally insured certificates of deposit. Yet this can be time and money well spent because the tax incentives of 529 plans outweigh the potential risks. Benefits include no AGI limitation for contributions, the ability to change investment allocations and plans annually, and earnings and distributions that are tax free as long as they pay for qualified education expenses.

For more information on 529 Plans, feel free to send us a comment or question below, or contact Mary Ida Garcia at mgarcia@BlackmanKallick.com or  312-980-2928. Our thanks to Greg Mudd for his contribution to this article.

This publication is part of Blackman Kallick’s marketing of professional services, and is not written tax advice directed at the specific facts and circumstances of any person and/or entity. Contents of this publication are of a general nature, and you should not act on this information without obtaining professional advice from your business advisor that is appropriately tailored to your individual needs and circumstances. This written advice is not intended or written to be used, and cannot be used by any taxpayer, for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.